OPTIMAL PLANT INVESTMENT PLAN
(Part 2)

DECISION ANALYSIS AND NPV

Last edit: Sept. 2003

GOAL: Combine decision analysis with NPV to evaluate a problem of choice under uncertainty.

GENERAL PROBLEM DESCRIPTION:

You still work for a major materials
manufacturer. Your boss examined the preliminary NPV analysis,

but has some concerns. While initial orders of two million parts/year are
guaranteed, there is some

uncertainty regarding the future rate of demand growth. Your initial
assessment used a single growth forecast.

You have now been asked to consider the implications if the growth rate
is twice the estimate,

or if no growth occurs. Further details are provided below.

PROBLEM OUTLINE:

Same basic details as in *
Optimal Plant Investment, Part 1.
*Initial demand always 2 million parts/ year.

Demand growth rate uncertain; for each of the following years it can follow one of these scenarios:

High: 3 million parts/year;

Medium: 1.5 million parts/year;

Low: 0 parts/year.

Each growth scenario has an equal likelihood of occurring (probability = 1/3).

Maximum demand remains 10 million parts/ year.

Use a discount rate of 10 percent and consider 10 years of sales.

ACTIONS:

(1) You should refer to the spreadsheet
you developed for *Part 1*. For each possible growth rate,

calculate the NPV for Plan A, Plan B with a capacity addition in Year 3,
and Plan B without a capacity

addition in Year 3.

Calculate the *expected NPV for each investment plan (probability
weighted average).*

(2) Build a decision tree which
compares Plan A and Plan B (with and without the capacity expansion

decided at Year 0). * Here the expansion decision is assumed to be fixed
in advance.*

(3) Revise the decision tree
to reflect the fact that the expansion decision is made in Year 3.

Build a decision tree that can be used to estimate the value of a
test which predicts demand growth with

certainty for this case of expansion being decided in Year 3. In short,
calculate the expected value of

perfect information, as described in the class presentations.

*Your report should include the three decision trees and a brief (one
page) summary with
recommendation and discussion of issues.*

Additionally, note that the
overall expected demand in any given year is exactly that estimated in Part
1

(i.e. expected growth rate equals 1.5 million parts per year). However,
the expected NPV calculated in *
Part 2 *does not equal the NPV calculated using the expected growth
rate.

and its implications (briefly).

NOTE FOR TREEAGE USERS:

(see TreeAge Manual or Instructions Summary for more detail)

When you create active links
between TreeAge and your spreadsheet, make sure that you have gathered

all your results on the same sheet and that you have named the cells.

If you enter the probabilities as variables, you will be able to perform
sensitivity analyses on these uncertainties.

TreeAge enables you to check for your EVPI calculation.